The Mortgage Professor: Questions, answers on reducing loan balance

Jack Guttentag, The Mortgage Professor (MCT)

Posted:
Saturday, March 22, 2014, 4:00 AM

Homeowners with a mortgage usually want to reduce their interest cost by paying down the loan balance as fast as possible. This column is about what borrowers can and cannot do on their own. Next week, I look at various schemes that claim to make the task easier.

QUESTION: Is there any benefit in making scheduled payments before the due date?

ANSWER: No. One of the many readers who have asked me this question told me that she was in the habit of making payments 6 months early. She was crestfallen to learn that this practice did not reduce her interest cost at all.

On a standard mortgage, interest accrues monthly, and is calculated by multiplying one-twelfth of the annual interest rate times the loan balance at the end of the preceding month. For example, if the loan balance is $100,000 and the interest rate is 6 percent, the interest due is 0.06 (divided by) 12 (times) 100,000, or $500. The borrower owes $500 regardless of when the payment is made or how many days there are in the month. If the payment is late by more than the 10 or 15 day "grace period," there is an additional late fee. But there is no rebate for paying early.

Simple interest mortgages, on which interest accrues daily, are an exception. On these mortgages, every day of delay in making the payment increases the interest cost, and paying early does reduce the borrower's interest bill. Simple interest mortgages used to be fairly common, but I am not aware of any being offered today.

Q: Do extra payments save more interest when made in some months?

A: No, the only valid rule is that the sooner you make the payment, the more interest you will save.

An idea that keeps popping up in my mailbox is that the best month in which to make extra payments to principal is January. It is certainly true that a January payment saves more interest than one made in the succeeding February, but it saves less than one made the preceding December.

Q: Is there a best time within the month to make an extra payment to principal?

A: Yes, the best time within the month to make an extra payment is the last day on which the lender will credit you for the current month, rather than deferring credit until the following month. If it is the 15th, for example, an extra payment made within the first 15 days of January will reduce your balance that month and the interest due in February. Payments made the 16th or later will not be credited until February, and the interest deduction will be deferred until March.

There is no universal lender practice in crediting extra payments. Some lenders will credit payments received anytime during the month, while others are much more restrictive. In most cases, extra payments sent in with the scheduled payment will be credited the same month, but it is a good idea to ask your lender what their rule is.

Q: Is there a best way in which to make an extra payment?

A: No, you can use the same payment method that you use to make your scheduled payment. Just bear in mind that the relevant date is when the payment is credited by the lender, not the date when you sent it.

A practice you should avoid is to make the extra payment an exact multiple of your scheduled payment. If that payment is $610.43, for example, don't make a payment of $1,220.86 – exactly double – because the lender will probably interpret the additional amount as an advance of your scheduled payment and hold it, rather than pay down your balance.

Q: Is there a best way to allocate extra payments when a borrower has two mortgages on the same property?

A: Yes, the general rule is to pay down the second mortgage first. Not only will the second have a higher rate, but second mortgages also can make life more complicated for borrowers looking to refinance or having payment difficulties.

The possible exception is a home equity line of credit, or HELOC, which might well carry a lower rate than the first mortgage, though it has high potential for future rate increases. The borrower who directs extra payments to a HELOC that has not yet reached the stage of mandatory repayment increases his credit line by the amount of the extra payment. This could be a desirable outcome for the borrower.

Q: Is there a best way to allocate extra payments when a borrower-investor has mortgages on several properties?

A: Yes, the general rule is that you save the most by paying down the mortgage with the highest interest rate first. One possible exception is where the mortgage that does not have the higher current rate is exposed to the most interest rate risk. For example, a borrower with a 4.5 percent fixed-rate mortgage and a 4 percent adjustable-rate mortgage, both in the early stages of their lives, might well elect to pay down the adjustable-rate mortgage because of the possibility that at some future time its rate could go as high as 9 percent.

Another possible exception would be when the lower-rate mortgage has a greater potential for a profitable refinance. For example, a 6 percent mortgage has a loan balance that is 89 percent of property value while a 5.75 percent mortgage is at 81 percent. If the extra payment directed to the lower-rate mortgage reduces the balance to 80 percent, no mortgage insurance would be required to refinance it.

A third possible exception is where the borrower-investor has so many mortgages that lenders refuse to finance any more acquisitions. Many lenders have a limit of 10. In that situation, the borrower looking toward further expansion wants a complete payoff ASAP and will concentrate all extra payments to the mortgage with the smallest balance.

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ABOUT THE WRITER

Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania. Comments and questions can be left at http://www.mtgprofessor.com.